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Tracking the Biggest Money Loser: Japan

(November 20, 2011)

Dear Subscribers and Readers,

Let's begin our commentary with a review of our 13 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

Over the last 12 months, the Nikkei 225 returned -16.4% and the TOPIX -17.1%.  Meanwhile, the S&P 500 rose 3.2% and the NASDAQ 4.5%.  Sure, the Japanese has been dealing with the aftermath of the March 11th earthquake.  Nonetheless, Japanese equity returns have been dismal, despite the strength of the Yen.  Only European and Hong Kong equities underperformed—the Euro Stoxx 50 returned -20.0% while the Hang Seng returned -18.9% over the last 12 months.

Focusing on a shorter time period—over the last three months, the worst performing major stock market has been the Japanese stock market, as shown in the following chart (courtesy of Goldman Sachs):

Investors who have bet bullishly in Japan since early 1990 have nearly lost money every time, and 2011 has been no exception.  The March 11th earthquake caused tens of billions of dollars in damages and disrupted Japan's supply chain that is crucial to its exports.  It also exposed the lack of political leadership and the lax regulation surrounding its nuclear power infrastructure.  Whatever credibility Japanese leaders and Japanese equities had coming into 2011 vanished very quickly.  The selling has continued despite very attractive valuations—with the exception of ROE—compared to both global equities and the domestic JGB yield (following charts courtesy of Goldman Sachs):

Not surprisingly, the second round of selling in Japanese equities this year came in August, just as the European Sovereign Debt crisis spiraled out of control.  While U.S. equities have recovered since August, Japanese equities have severely underperformed, given its relatively large exposure to the global economy and exports (at least relative to U.S. companies).  In addition, a significant portion of Japanese equities is held by foreign investors, and many of them are still evaluating the effects of the European Sovereign Debt Crisis on their Japanese holdings.  As shown in the following chart (courtesy of Goldman Sachs) foreign selling has been instrumental in depressing Japanese stock prices over the last three months:

While we are not advocating any long position on Japanese stocks, the recent sell-off in Japanese equities, along with the cheapest valuations in the developed world, suggests there may be selective opportunities in purchasing Japanese stocks (Japanese financials may be a consideration).  For now, we still anticipate a further correction to global equities.  However, we believe any correction (at least in the Dow Industrials) will be rather limited, given the decent valuations of U.S. large cap stocks.  As such, we are looking to initiate a 50% long position in our DJIA Timing System should the Dow Industrials decline below the 11,250 level.  Let us now discuss the most recent action in the U.S. stock market using the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from July 2008 to the present:

For the week ending November 18, 2011, the Dow Industrials declined 357.52 points, while the Dow Transports declined 136.94 points.  While the market is oversold in the short-run, we are still cautious because of the ongoing problems in the Euro Zone and the weakness in our liquidity indicators.  As such, we believe the correction will extend towards the end of this year.  While we no longer think the Dow Industrials will revisit the sub-11,000 level (unless Italy exits the Euro Zone), we will only initiate a 50% long position should the Dow Industrials fall below 11,250.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The four-week moving average of these sentiment indicators increased from 4.4% to 7.5% for the week ending November 18, 2011.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 2001 to the present:

The four-week MA rose a whopping 18.8% from a severely oversold level of -11.3% over the last six weeks. Given our weakening technical indicators and the ongoing European Sovereign Debt Crisis, we will remain cautious until the four-week MA hits oversold territory again.  Again, we may initiate a 50% long position in our DJIA Timing System, but only should the Dow Industrials fall below the 11,250 level.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

The decline of the 20 DMA below the 50 DMA is a somewhat bearish development, although given the severely oversold condition of this indicator, I do not expect much downside from here.  However, given the significant volatility and potential “Black Swan” events, we will refrain from initiating a 50% long position until the Dow Industrials decline to 11,250 or below.

Conclusion: We cringe whenever we hear a suggestion to purchase Japanese equities, given that Japanese equities have been the biggest money loser for the last 20 years.  That said, there may be selective opportunities in purchasing Japanese equities (Buffett's latest trip to Japan supports this idea), given the cheap valuations and the recent sell-off in Japanese stocks.  For now, the lack of fear in the market (as indicated by low recent volatility and the VIX) is worrying from a bullish standpoint, given the worsening conditions in the Italian sovereign debt market, which could lead to an eventual break-up of the Euro Zone and severe asset mark-downs in the region.  That said, while the market remains vulnerable in the short-run due to the ongoing European Sovereign Debt Crisis and the short-term overbought conditions, valuations suggest that 2012 will be an up year. We remain neutral in our DJIA Timing System; but may initiate a 50% long position should the Dow Industrials fall below the 11,250 level.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

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